EPCRS Streamlined to Make Voluntary Correction Generally More Attractive to Small Businesses

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1 Article September 2003 EPCRS Streamlined to Make Voluntary Correction Generally More Attractive to Small Businesses By Fred Reish The complexity of the retirement plan provisions in the Code and Regulations seems to guarantee that mistakes will be made, somewhere along the line. IRS has recognized for a long time that it is in everyone's best interest to encourage prompt and effective voluntary correction of defects in plan operation. In Rev. Proc , the IRS effectively continues its effort to better coordinate and simplify its remedial programs to encourage compliance. Achieving a good result under those programs, however, still requires plan sponsors and/or their advisors to carefully consider their options before approaching the IRS. Over the past decade, the IRS has evolved its programs for correcting compliance failures in qualified plans and other retirement vehicles. On 6/4/03, the Service released Rev. Proc , IRB 1051, the latest iteration of the Employee Plans Compliance Resolution System (EPCRS). As now embodied in the new Procedure, EPCRS is the consolidation of the Service's remedial programs for qualified plans, Section 403(b) arrangements, 1 simplified mployee pension plans (SEPs), and SIMPLE IRA plans. Rev. Proc reflects a significant rethinking and simplification of the procedural aspects of the remedial programs, a modest expansion of the programs, but relatively few substantive changes. The changes make IRSsupervised correction significantly less complex and, in certain cases, substantially less expensive. This should generally promote voluntary compliance and make it particularly more attractive to small businesses - especially those that sponsor SIMPLE IRAs and SEPs. The Procedure does not make material changes in the operation of the Self Correction Program (SCP) or the Audit Closing Agreement Program ("Audit CAP"). Notwithstanding the simplification and reduction in cost under Rev. Proc , however, it is clear that EPCRS still places a high premium on careful assessment of the plan defects to determine the most advantageous form of correction. Rev. Proc is generally effective 10/1/03. Plan sponsors, however, are permitted to apply its provisions to any failure after 6/4/03. OVERVIEW OF EPCRS The Service's correction programs for qualified plans, Section 403(b) arrangements, SEPs and SIMPLE IRA plans began modestly in 1990, when the IRS introduced the first in a series of administrative programs designed to avoid the severe, adverse effects of plan disqualification. 2 Over the next three or four years, the Service gradually expanded and modified the programs, largely in response to plan sponsor pressure to facilitate the correction of self-discovered defects in a wider variety of circumstances and for a wider array of plan types. These programs permitted sponsors of qualified plans and other retirement vehicles with "qualification failures" 3 to retroactively fix those defects and, thus, maintain the plan's qualified status. Each of these remedial programs had different eligibility requirements, addressed different types of violations, required varying methods of correction, and required the plan sponsor to deal with different parts of the IRS. In 1998, the IRS issued Rev. Proc , CB 723, which modified, restated, and consolidated its remedial programs for plan qualification defect into a single, comprehensive system - EPCRS. 4 Under Rev. Proc , EPCRS began to use specific terminology to describe various types of plan defects, as follows: Operational Failure. An "operational failure" is a failure to follow the terms of the plan document. This is

2 true even if the plan operation would have been permitted under the qualified plan rules had the document been written in conformance with such operation. 5 Plan document failure. A "plan document failure" exists if a plan provision violates the requirements of Section 401(a) or if a qualification failure does not fall within one of the other categories of defects described under EPCRS. 6 Demographic failure. A "demographic failure" is a failure to satisfy the nondiscrimination testing requirements of Section 401(a)(4), the coverage requirements under Section 410(b), or the minimum participation requirements of Section 401(a)(26), that requires a substantive amendment to the plan document to correct. 7 Egregious Operational Failures. An "egregious operational failures" is defined under EPCRS only by way of a couple of examples 8 Diversion or Misuse of Plan Assets. A "diversion or misuse of plan assets" is a violation of the rule in Code section 401(a) that plan assets must be held for the exclusive benefit of plan participants and their beneficiaries. Generally speaking, the IRS will determine that there has been a violation of the "exclusive benefit rule" only in cases where there has been a substantial diversion or misuse of plan assets (the general rule of thumb is that 70% or more of the plans' assets must be involved). EPCRS has never been available to correct failures relating to the diversion or misuse of plan assets. 9 The programs included in EPCRS under Rev, Proc were as follows: 1. The Administrative Policy Regarding Self-Correction (APRSC), which permitted a plan sponsor to voluntarily self-correct any Operational Failure without IRS supervision by the last day of the second plan year following the plan year in which the failure occurred, and to correct "insignificant" defects at any time, even if the plan was undergoing an IRS audit. Because of the lack of IRS oversight of the correction, as a condition of eligibility for the program APRSC required that, at the time the operational failure occurred, the plan had in place practices and procedures reasonably designed to prevent the failure. Such practices and procedures must have been routinely followed, but through oversight, a mistaken application, or perhaps an inadequacy in the procedures themselves, the operational failure occurred. 2. The Voluntary Compliance Resolution (VCR) program, which was a voluntary program similar to APRSC for resolving operational failures with IRS supervision. The primary differences between VCR and APRSC were that VCR involved (a) disclosure of the failure to the IRS through the filing of a formal application with the IRS in Washington, DC, (b) the payment of a fixed "compliance fee" based on the size of the plan, and (c) formal IRS approval of the method of correction through the issuance of a "compliance statement" that describes the terms of the correction. VCR, unlike APRSC, did not distinguish between significant and insignificant operational failures, and there was no limit on the time in which the plan sponsor had to correct the failure. 3. The Standardized VCR Procedure (SVP), which was a sub-set of VCR that provided for expedited processing (120 days) and a limited filing fee ($350.00). The qualification failures eligible for correction under SVP were the seven specified operational defects set forth in Appendix A of Rev. Proc The Walk-in Closing Agreement Program ("Walk-in CAP"), which was a voluntary program that operated in much the same way as VCR, except the fee was usually significantly higher and the application was filed with a "closing agreement coordinator" in the local IRS area office. Under Walk-in CAP, a plan sponsor could correct plan document failures (in fact, this was the only program under which such failures could be resolved), operational failures, demographic failures, and egregious failures. The only eligibility requirement for Walk-in CAP was that the plan could not be under audit at the time the application was filed. 5. The Audit Closing Agreement Program ("Audit CAP"), under which plan document failures, demographic failures, and operational failures discovered by the IRS on audit could be corrected. In Rev. Proc , the IRS also requested comments from the public on the operation of the programs and announced its intention to issue a new Revenue Procedure every year to incorporate new concepts, corrections

3 and procedures. Accordingly, the next iteration of EPCRS came in Rev. Proc , CB 280. This version preserved the SVP corrections and provided 25 examples for correcting common operational failures (including detailed examples on how to calculate earnings on corrective contributions or distributions). The correction examples provided guidance for several operational failures which had not previously been covered by SVP (i.e., defects relating to vesting, compensation, and hardship distributions), and also expanded on or provided alternatives to the SVP corrections for certain types of defects. In short, Rev. Proc was important because it provided additional guidance on specific corrections that the IRS would accept under any of the programs covered by EPCRS. 11 This made self-correction without IRS supervision more accessible and potentially fostered greater compliance with the rules. The following year, the major change in Rev. Proc , CB 518, was to expand SVP to specifically include the operational failures and correction guidance provided in Rev. Proc The original SVPmandated forms of correction, along with the additional guidance from Rev. Proc , were incorporated into new appendices that identified 13 types of operational failures eligible for self-correction with minimal IRS supervision under SVP. The guidance in the appendices was important not only because it gave plan sponsors "pre-approved" correction methods that could be used under SVP but also because it provided them with greater opportunity under APRSC to correct without IRS supervision, and to do so with the assurance that the method of correction would he acceptable if the Service later discovered the failure during an audit of the plan. Rev. Proc also incorporated into EPCRS the Tax-Sheltered Annuity Voluntary Correction program (TVC) for correction of defects occurring in Section 403(b) arrangements. TVC previously had been introduced in Rev. Proc , and consisted of a comprehensive correction system for operational, demographic or eligibility failures. The program was similar to Walk-in CAP, in that it enabled sponsors of Section 403(b) arrangements to voluntarily disclose and correct defects with the IRS, and pay a fee in exchange for closing agreement. 12 In January 2001, the IRS released Rev. Proc , CB 589, which made several substantive and procedural changes to EPCRS. The most noteworthy changes 13 were the following: 1. Consolidation of VCR, Walk-in CAP and TVC. The voluntary correction programs involving IRS approval - consisting of VCR, Walk-in CAP and TVC - were consolidated into a single program called the Voluntary Correction Program (VCP). While VCP provided general procedures for correcting all qualification failures - operational, plan document, demographic and a new failure called "employer eligibility" (explained below) - the program still had different procedures depending on the type of defect or type of plan involved. VCP included three parts: (a) "Voluntary Correction of Operational Failures" (VCO), (b) "Voluntary Correction of Operational Failures Standardized" (VCS), and (c) "Voluntary Correction of Tax-Sheltered Annuity Failures" (VCT). Corrections of only operational failures were handled under VCO, which was roughly the equivalent of the old VCR program. Corrections of operational failures using standardized, pre-approved correction methods were covered by VCS. And, VCT essentially replaced the old TVC program. 2. Voluntary corrections approved through a compliance statement. After Rev. Proc , all voluntary corrections were approved by the issuance of a "compliance statement," as opposed to a closing agreement, as had been used for plan documents and demographic failures under Walk-in CAP. 3. Group submissions: The introduction of VCGroup. Under VCP, the IRS began permitting certain organizations, such as master and prototype sponsors or third-party administrators, to receive a compliance statement for correcting failures that affected more than one plan sponsor (i.e., "systemic" defects). The IRS called this program "VCGroup." 4. Introduction of the "anonymous submission procedure." As a part of VCP, the IRS established a formal "Anonymous Submission Procedure" to permit submissions of qualified plans and 403(b) arrangements without initially identifying the plan or plan sponsor. (Since the mid-1990s, a number of the IRS offices had been permitting anonymous or "John Doe" submissions on an informal basis.) Failures involving "safe-harbor" defects and corrections (i.e., the defects previously covered by SVP) were not eligible for this procedure.

4 5. Self-correction change. The Administrative Policy Regarding Self-Correction (APRSC) was renamed the "Self- Correction Program" (SCP). 6. Correction for SEPs. VCP was expanded to include a correction procedure for SEPs. This was the first time a plan other than a qualified plan or 403(b) arrangement had been eligible for the remedial programs. The new procedure was called "Voluntary Correction SEPs" (VCSEP). 7. Introduction of the "employer eligibility failure." Rev. Proc enabled plan sponsors to correct a type of defect called an "employer eligibility failure" under VCP, VCT or VCSEP. An employer eligibility defect includes, among other things, (i) the adoption of a cash or deferred arrangement intended to satisfy the requirements of Code section 401(k) for one or more years between 1987 and 1996 by an employer that was a tax-exempt organization prohibited from adopting a 401(k) arrangement during that period; and (ii) the adoption of a plan intended to satisfy 403(b) by an employer that is not an eligible tax-exempt organization. Employer eligibility failures are separate and distinct from plan document, operational and demographic failures, and are not eligible for correction under SCP. 14 In June 2002, the IRS issued Rev Proc , IRB 133, which did little more than add a few minor clarifications and refinements to the fairly sweeping changes made to EPCRS under Re Proc NEW CHANGES The latest guidance on EPCRS represents a significant effort on the part of the Service to streamline the process of IRS-supervised self-correction and to create a more logical system. Until Rev. Proc , the correction programs reflected their heritage, that is, even though billed as a single program or "system," it still was apparent that EPCRS had been created by lumping together a series of programs that had been designed and implemented separately The newest Procedure, however, establishes a truly integrated system that is more internally consistent than any of its predecessors. Nevertheless, the changes in EPCRS brought about by Rev. Proc remain more process-driven than substantive. Consolidation of All Voluntary Programs into VCP Since Rev. Proc ,VCP has provided general procedures for IRS-supervised correction of all qualification failures - operational plan document, demographic and employer eligibility. VCP also included special procedures far corrections of (1) operational failures under VCO, (2) operational failures using standardized, preapproved correction methods under VCS, (3) failures in Section 403(b) arrangements under VCT, (4) failures in SEPs under VCSEP, and (5) plan document and demographic failures, which fell under the VCP general procedures program. Now under Rev Proc , section 1.03, one voluntary correction procedure under VCP replaces all of the following: VCP general procedures, VCO, VCT, VCSEP, and - perhaps most surprisingly - VCS. The consolidation simplifies the procedures for making an application under the remedial programs by eliminating the need to consider any special requirements that apply to a particular program. This will make VCP substantially more user friendly. With respect to the elimination of VCS, the IRS had intended that program to be an expedited process under which plan sponsors received a reduction in the fees and faster processing, in exchange for using a mandated, pre-approved or safe harbor form of correction. The Service discovered, however, that it was taking almost as much time to process VCS applications as "standard" applications, because plan sponsors sought to use the procedure without meeting its requirements. As a practical matter, therefore, the elimination of VCS will not have a significant impact an EPCRS. Fixed Fee Schedule for All Voluntary Applications Previously, the fee charged by the IRS for resolving failures under one of its voluntary programs (i.e., VCO, VCS, VCT, VCSEP, and VCP General Procedures (the successor to Walk-in CAP)) was a negotiated amount, albeit within a range based on the amount of plan assets and the number of participants. With the exception of "egregious failures" (where the fee remains a negotiated amount of not more than 40% of the total taxes that would due upon plan disqualification, i.e., the "maximum payment amount" 15 ), Rev. Proc eliminates any negotiation with respect to fees for voluntary applications by providing for a fixed fee schedule.

5 The new fees (shown in Exhibit 1 on this page) are a significant reduction from the previous "presumptive" amounts - as much as 75% in the case of smaller plans to about 30% for larger plans. Exhibit 1 New Fixed Fee Schedule for Voluntary Applications Under Rev. Proc Number of Participants/Employees Fee 20 or fewer $ to 50 $ 1, to 100 $ 2, to 500 $ 5, to 1,000 $ 8,000 1,001, to 5,000 $15,000 5,001 to 10,000 $20,000 Over 10,000 $25,000 The fee schedule applies to qualified plans and Section 403(b) arrangements (including anonymous submissions). For Section 403(b) arrangements, the fee is determined with reference to the number of employees, rather than participants. 16 The fees for non-amenders are also determined in accordance with the new fee schedule - gone are the variations based an the specific law with which the plan failed to comply. If, however, the plan sponsor submits the VCP request within the one-year period following the expiration of the plan's remedial amendment period, 17 the fees are reduced by 50%. 18 The fee for SIMPLE IRAs and SEPs is a flat $ The group submission fees have been reduced to $10,000 for the first 20 plans and $250 for each additional plan, up to a maximum of $50,000 (previously $90,000). 20 Finally, for all VCP requests, the fee must be submitted with the initial application and need not be paid in the form of a certified or cashier's check. 21 The reduction in fees as compared to the prior VCP general procedures fee schedule is dramatic - the fees for most ranges of plan size have been effectively reduced by one-half or more (see Exhibit 2 on this page). Thus, the Rev. Proc makes the voluntary correction of plan document and demographic failures (and any other defects that do not precisely fall within the definition of an operational failure) substantially more affordable. This should promote the use of VCP to correct these types of defects, particularly by small businesses ¾ many of which have previously opted to play "audit roulette" rather than pay the required compliance fee. Exhibit 2 Old 'General Procedures' Fee Schedule for Voluntary Applications Under Rev. Proc The following table reflects the VCP general procedure compliance fee schedule under Rev. Proc Section 12.01(1). Items marked by asterisk refer to the VCO compliance fee that would apply under section if the plan had been submitted under VCO. # of participants Fee range Presemptive Amount 10 or fewer VCO fee* to $4,000 $2, to 50 VCO fee* to $8,000 $4,000

6 51 to 100 VCO fee* to $12,000 $6, to 300 VCO fee* to $16,000 $8, to 1,000 VCO fee* to $30,000 $15,000 Over 1,000 VCO fee* to $70,000 $35,000 In addition, the lower fees should make VCP more attractive in all cases where the desired method of correction is other than an IRS-approved method (i.e., other than one of the "safe-harbor" corrections described in Appendices A or B of Rev. Proc ). In these situations, the lower fees will likely outweigh the risk of having the IRS discover the defect and determine that the method of correction was improper - and, therefore, that the defect must be resolved under Audit CAP accompanied by the payment of a substantial sanction. The new fee schedule is substantially less favorable, however, when compared to the fees available under the prior VCO program for correcting purely operational failures (see Exhibit 3 on this page). This is a matter of concern, because it potentially creates a strong disincentive when it comes to voluntarily correcting these types of defects. That is, where the operational failure is either (1) ineligible for correction under SCP (i.e., the defect is significant and the two-year self-correction period has passed) or (2) the desired method of correction is other than an IRS-approved method (i.e., other than one of the safe-harbor corrections described in Appendices A or B of the Rev. Proc ), the higher fees may make plan sponsors more willing to take the risk that the IRS will discover the defect (and, perhaps, also determine that the method of correction was improper) and "force" the sponsor to resolve it under Audit CAP by paying a substantial sanction. Exhibit 3 Old Fee Schedule for VCO Applications Under Rev. Proc The following reflects the VCO fees, which depended on the assets of the plan and the number of plan participants, under Rev. Proc , section 12.02, where VCS was not applicable. Assets Participants Fee Less than $500,000 No more than 1,000 $ 500 At least $500,000 No more than 1,000 1, More than 1,000 but fewer than 10,000 5, ,000 or more 10,000 Finally, the Rev. Proc effectively codifies the special non-amender programs the IRS has provided for prompt correction after the end of the remedial amendment period by lowering the fee to one-half the otherwise applicable amount. Thus, unless the rules change again, the next time there is a remedial amendment period the IRS will not need to consider providing for special fees for late amenders, as they did with TRA '86 and GUST. Existing Correction Guidance Extended in Both SIMPLE IRAs and SEPs The new Procedure expands EPCRS to cover SIMPLE IRA plans, and generally extends its existing correction guidance to both SIMPLE IRAs and SEPs. The latter is accomplished by defining "reasonable and appropriate" correction for these arrangements to include the correction methods permitted under Appendices A and B of Rev. Proc While practitioners had commonly believed the guidance in the appendices applied to SEPs, the IRS had not previously indicated that this was the case. EPCRS' coverage of SIMPLE IRAs, however, is entirely new. Thus, the correction methods for SIMPLE IRAs and SEPs are very similar to those for qualified plans. For certain failures, however, the Rev. Proc provides specific correction methods and reporting requirements that are unique to the circumstances of SIMPLE IRAs and SEPs. 23 Correction under VCP and Audit CAP is available to both SIMPLE IRAs and SEPs. 24 SCP is available if the defect is both an operational failure (i.e., a failure to follow the terms of the plan document) and "insignificant,"

7 provided the SIMPLE IRA or SEP is established and maintained pursuant to an IRS-approved document (i.e., an approved prototype or volume submitter document). 25 Finally, Rev. Proc also expands the anonymous and group submissions procedures to apply to SIMPLE IRAs and SEPs. 26 Without question, the new EPCRS Procedure is good news to the many small employers that opt to sponsor SIMPLE IRAs and SEPs. Now these businesses have clear guidelines upon which they can rely in fixing many of the problems that occur in their retirement vehicles. These changes indicate an increased awareness by the IRS of the lack of compliance in a largely unregulated area of the retirement plan world - and its commitment to do something about it. New Guidance Affecting Participant Loans Section 72(p) and the regulations thereunder discuss the extent to which loans from a qualified plan are treated as taxable distributions. They provide guidance on how a participant loan can be structured so that it is exempt from such treatment. Strictly speaking, a violation of Section 72(p) does not entail a qualification failure; it results in immediate taxable income to the participant receiving the loan. (The participant, of course, does not receive an actual "distribution" from the plan. Rather, the distribution is "deemed" to have occurred for tax purposes based on the loan proceeds.) If, however, the plan document incorporates one or more of the Section 72(p)(2) provisions that enable a participant to take a loan from a plan on a non-taxable basis, any violation of those plan provisions amounts to an operational failure for failing to follow the plan's written terms. For example, a plan document could be written to take into account Code section 72(p)(2) by specifically providing that participants loans (i) are not to be made in excess of the Code section 72(p)(2)(A) maximum amount (e.g., the lesser of $50,000, or the greater of (1) one-half the participant's vested accrued benefit or (2) $10,000); (ii) must be repaid within 5 years; and/or (iii) must be amortized on a substantially level basis over the life of the loan. If the plan were written in this manner, then a failure to comply with any of these provisions would result in a qualification failure. If a participant loan results in a qualification failure as described above, it can be corrected under EPCRS by filing an application under VCP. The additional income tax consequences resulting from the failure to comply with one or more of the exemptions under Section 72(p) still will apply, however. 27 Thus, the participant would be required to report, as taxable income, the balance of the loan in the year it became a deemed distribution. In most cases, violations involving participant loans are not discovered until long after they occur and the participant has filed his or her tax return for the year of the resulting deemed distribution. This means the participant now has additional taxable income for a prior year, and is faced with the burden of having to file an amended tax return. Plan sponsors and their advisors have long requested relief from the usual reporting requirements for deemed distributions under Section 72(p). And, in Rev. Proc , the IRS has provided such relief. Section 6.07 states that "[a]s part of VCP, in the event of a failure relating to a loan to a participant made from a Qualified Plan or a 403(b) Plan that is treated as received as a distribution for purposes of 72(p) (a deemed distribution), the distribution may be reported on Form 1009-R for the year of correction with respect to the affected participant." Thus, the IRS has now provided for a special rule the case of a deemed distribution that result in qualification failure. That rule permits plan sponsors who file a VCP application to correct the qualification failure to report the deemed distribution for the year of correction. This is a welcome change, because it simplifies the tax filing requirements for plan participants. In addition, because the new procedure is contingent upon the use of VCP, it provides a greater incentive for plan sponsors to voluntarily correct qualification failures arising out of deemed distributions. Audit CAP Sanctions-Subtle but Significant Revision As under prior iterations of EPCRS, Rev. Proc indicates that the sanctions under Audit CAP will be a negotiated percentage of the maximum payment amount and "will bear a reasonable relationship to the nature, extent, and severity of the failures" based on certain specified, nonexclusive factors. 28 One of the factors previously included was "the amount of the fee the Plan sponsor would have paid under [VCP] for correcting the

8 failures." 29 The Rev. Proc. eliminates that factor. 30 While perhaps a seemingly innocuous change, the elimination of this factor sends a clear signal that the IRS intends for the Audit CAP sanction to be more than the VCP correction fee - and perhaps significantly more than what we have seen in recent history. This puts a premium on the ability to negotiate not only the most favorable method correction but also the sanction. In addition, with respect to qualified plans, Rev. Proc adds the factor of "whether the failure(s) were discovered during the determination letter process." 31 At this point, it is too early to project the extent to which this factor will affect the sanction. Presumably, however, a plan that elects to submit for a favorable determination letter (FDL) ruling, and then has defects discovered during the course of the review process, would appear far more "voluntary" in nature than a plan that has its defects discovered on audit. Thus, the effectiveness of the new FDL factor would appear to rest on the ability of the plan sponsor and/or its advisors to use the facts and circumstances of the plan, the FDL application and the particular defect(s) to emphasize how close the defect came to being voluntarily disclosed to the IRS. EPCRS Is Now Available to Correct EGTRRA Non-Amenders Another useful change to EPCRS made by Rev. Proc relates to EGTRRA. EPCRS is now available to correct qualified plans that have failed to timely adopt good faith plan amendments to reflect that Act. The VCP application must include the good faith amendments and they must be adopted within the time period specified in the compliance statement. Because the Service's determination letter program is not yet open for EGTRRA amendments, a determination letter will not be issued in conjunction with the issuance of the compliance statement, unless the plan is a terminated plan. Terminated plans must submit a Form 5310 determination letter application and will receive both a compliance statement and a determination letter upon completion of the VCP process. 32 Anonymous and Group Submission Procedures As indicated above, Rev. Proc expands the anonymous and group submissions procedures to apply to SIMPLE IRAs and SEPs. 33 The anonymous submission (as noted above, also commonly known as "John Doe") procedures contain new guidance explaining precisely when to submit the power of attorney statement, penalty of perjury statement and related determination letter application (within 21 days of the date the IRS and the plan sponsor reach an agreement with respect to the submission.) The group submission procedures, used by "eligible organizations" (i.e., sponsors of a master or prototype plan, an insurance company or a third-party administrator) to correct systemic errors occurring in the plans to which they provide services, were simplified by eliminating the requirement for a power of attorney for each affected plan. Rather, eligible organizations must provide notice to affected plan sponsors regarding the group submission. And, once the compliance statement is issued, the eligible organization must submit a certification that each affected plan sponsor received the notice. The eligible organization must provide the notice at least 90 days before it provides the required certifications and identifying information regarding the affected plans to the IRS. Individual plan sponsors remain free to opt out of the group submission procedure. Thus far, eligible organizations as a whole have not made widespread use of the group submission procedure. Given the changes described above and the significant reduction in fees, Rev. Proc has made the group submission procedure more attractive, which should increase its use. New Procedure for Correcting Failures to Obtain Spousal Consent Prior to Rev. Proc , the only written guidance under EPCRS for the failure to obtain participant and/or spousal consent for a distribution subject to Sections 401(a)(11) and/or 417 was the form of correction described in Appendix A, section.07, of the EPCRS Revenue Procedure, which was the required form of correction under SVP (referred to herein as the "SVP correction"). The SVP correction requires the plan sponsor to give the affected plan participant and the spouse a choice between receiving a qualified joint and survivor (QJSA) and signing an informed consent for the distribution

9 already received. As a prerequisite to using the SVP correction, the plan sponsor must contact all affected participants and their spouses before filing a voluntary application with the IRS to correct the failure. Under the SVP correction, if a plan discovers that a distribution subject to the QJSA rules was made to a married participant in another form, without an appropriate election and/or spousal consent, the correction is as follows: 1. If a married participant's consent cannot be obtained, the plan must give the participant a QJSA based on the monthly benefit amount that would have been provided under the plan at the retirement date, which can be offset by any amounts already received by the participant. (Thus, if the participant has already received a single-sum distribution that is the actuarial equivalent of the QJSA, no further distribution to the participant is required.) 2. If the consent to the participant's spouse cannot be obtained, the plan sponsor must provide a survivor annuity to the spouse (to whom the participant was married at the time of the erroneous distribution). The spousal survivor annuity cannot be offset by any amount previously received by the participant. (Thus, under the SVP correction, the plan may be required to distribute a combined amount to the participant and the spouse that is more than the amount that would have been required if the proper consents had been timely obtained.) 34 A problem that frequently arises in attempting to use the SVP correction is that often the affected spouse cannot be located or fails to respond. This effectively can prevent the plan from using the SVP correction, due to the requirement that all affected spouses must be contacted before filing an application with the IRS. To deal with this problem, Rev. Proc provides that if spousal consent cannot be obtained because the spouse refuses to consent, fails to respond, or cannot be located, then the QJSA must be provided only if the spouse later comes forward and actually makes a claim for benefits. Thus, under the new Procedure a plan sponsor that takes appropriate action to notify the affected spouse of the prior erroneous distribution, but does not - or cannot - receive a response, is considered to have fully corrected the defect as to the spouse. If the spouse later comes forward and actually makes a claim for benefits, the plan sponsor is required to provide him or her with the death benefit that would have been paid under the plan if the participant has received the QJSA. 35 This is not the first time the IRS has been willing to take into account the difficulty in obtaining responses to notices regarding failures under Section 401(a)(11) and 417. Under the prior Walk-in CAP and VCR programs, plan sponsors were sometimes successful - depending on the particular facts and circumstances of the case - in obtaining IRS approval to treat the failure of the participant or spouse to respond within a reasonable period of time to the notice of a QJSA violation as a waiver of the QJSA form of benefit. In those instances, the IRS generally regarded 15 to 30 days as a reasonable period of time for the affected participant and spouse to respond. Now that the IRS has directly addressed the issue of how to handle a non-response to a notification of a QJSA failure, it is unlikely that any alternative forms of correction will continue to be - to any extent - acceptable under EPCRS. That is, because the Service has considered this issue and chosen in Rev. Proc to alter the SVP correction only with respect to the spouse and only to the extent of requiring him or her to assert a benefit claim in order to receive the death benefit, it is unlikely the IRS will be willing to deviate from its written guidance in this regard. Furthermore, the Service's new guidance regarding the failure to obtain spousal consent is consistent with the long-standing correction principles of EPCRS and complies with Title I of ERISA. Rev. Proc , section 6.12, states that "[c]orrection under these [remedial] programs has no effect on the rights of any party under any other law, including Title I of [ERISA]." Thus, the Service's guidance in new Procedure correctly takes into account that a non-response under EPCRS cannot have the effect of waiving a participant's or spouse's right to benefits under Title I of ERISA. Given that the IRS has now provided additional guidance on how to correct the failure to obtain spousal consent, and such guidance is consistent with Title I or ERISA, it would be particularly risky for plan sponsors to attempt to use alternative correction methods for this failure under SCP. 'Under Examination' Clarified Rev. Proc clarifies that a plan for which any determination letter application has been submitted may be considered "under examination." Previously, EPCRS specifically referred only to a Form 5310 determination

10 letter application in this regard. 36 Specifically, section 5.03(3) of Rev. Proc provides as follows (with the changes from the prior version highlighted): "An Employee Plans examination also includes a case in which a Plan Sponsor has submitted any Form 5300 series form and the Employee Plans agent notifies the Plan Sponsor, or a representative, of possible Qualification Failures, whether or not the Plan Sponsor is officially notified of an 'examination.' This would include a case where, for example, a Plan Sponsor has applied for a determination letter on plan termination, and an Employee Plans agent notifies the Plan Sponsor that there are partial termination concerns. In addition, if during the review process, the agent requests additional information that indicates the existence of a Qualification Failure(s) [sic] not previously identified by the Plan Sponsor, the plan is considered under an Employee Plans examination. The fact that a Plan Sponsor voluntarily submits a determination letter application does not constitute a voluntary identification of Qualification Failures to the Service. In order to be eligible to perfect a determination letter application into a VCP submission, the Plan Sponsor (or the authorized representative) must identify each Qualification Failure, in writing, to the reviewing agent before the agent recognizes the existence of the Qualification Failure(s) and/or addresses the Qualification Failure(s) in communications with the Plan Sponsor (or the authorized representative)." This means that if a plan sponsor submits any Form 5300 series application and an Employee Plans (EP) agent notifies the plan sponsor or its representative of an actual or potential qualification failure, the IRS may immediately consider the plan to be "under examination" and thus ineligible to correct the defects under VCP. If this occurs in order to preserve the plan's qualified status the plan sponsor would have to correct the defect(s) under the Audit CAP, which requires the payment of a negotiated -- and often substantial -- sanction. Plan sponsors should be aware that the IRS may apply these rules extremely liberally. Thus, the Service may consider a plan to be "under examination" as of the date an EP agent requests any information leading to the discovery of a defect not voluntarily identified to the IRS. This places a high premium on careful review of the plan's documentation and operation prior to submitting it for review under the determination letter program. If such review identifies a defect, SCP and/or VCP should be fully considered before the determination letter application is filed. Sample Application Formats Rev. Proc provides two sample formats to assist practitioners in preparing VCP submissions. One sample consists of a generic format that can be used for all types of submissions other than for nonamenders. The other sample is specifically for nonamenders. 37 Other Clarifications and Changes In addition to the significant changes described above, Rev. Proc provides clarifications or minor changes regarding the following matters. 1. A determination letter application must be filed for any demographic failure being corrected under VCP by a plan amendment. The prior versions of EPCRS provided that "in the case in which correction of a Qualification Failure includes correction of a Plan Document Failure or correction of an Operational Failure by plan amendment,... other than adoption of an amendment designated by the Service as a model amendment or standardized prototype plan, the amendment must be submitted to the Service for approval using the appropriate application form... to ensure that the amendment satisfies applicable qualification requirements" 38 EPCRS did not specifically require that a determination letter application be filed in connection with the correction of a demographic failure. Nevertheless, because correction in this situation generally requires an amendment to the plan to permit additional participation, it was assumed by most retirement plan professionals that such an application was required. In Rev. Proc , the IRS clarifies this issue by specifically stating that determination letter applications also will be required for demographic failures that are corrected under VCP by a plan amendment Reasonable estimates may be used where it is impossible to provide plan data. The prior version of EPCRS provided for an exception to the general rule that "a failure is not corrected unless full correction is made with respect to all participants and beneficiaries, and for all taxable years (whether or not the taxable year is closed)." 40 That exception permitted the use of "reasonable estimates" if it was impossible "to make a precise calculation, or the probable difference between the approximate and the precise restoration of a participant's benefits is insignificant and the administrative cost of determining the precise restoration would significantly

11 exceed the probable difference..." 41 In practice, plan sponsors and their advisors have typically assumed that the absence of data enabled them to use reasonable estimates in correcting defects under EPCRS and, in fact, the IRS has approved many corrections on this basis. In Rev. Proc , the IRS clarifies this issue by stating specifically that reasonable estimates may also be used where "it is not possible to make a precise calculation (for example, where it is impossible to provide plan data)... " A plan sponsor is required to provide proper notice regarding tax treatment to a participant who receives an overpayment from the plan, regardless of whether the overpayment amount is de minimis. Under EPCRS the plan sponsor is generally required to seek the return of any overpayments from the plan, and provide notice to the participant who received the overpayment that such amount is not eligible for favorable tax treatment - and specifically not eligible for a tax-free rollover. 43 The prior version of EPCRS provided that in the case of a "recovery of a small overpayment" ($100 or less), the plan sponsor was not required to seek return of the overpayment amount, but there was no mention of whether the plan sponsor was still obligated to provide notice regarding the tax treatment of the overpayment. 44 In Rev. Proc the IRS clarifies this issue by specifically providing that even in the case of a small overpayment, the plan sponsor "is required to notify the participant or beneficiary that the Overpayment is not eligible for favorable tax treatment accorded to distributions form Qualified Plans (and, specifically, is not eligible for tax-free rollover.) A failure to reach resolution under VCP will result in a forfeiture of all or some of the filing fee. Under the prior version of EPCRS, the IRS indicated that a failure to agree on a resolution of the application may open up "all aspects of the plan" to review by Employee Plans Examination. 46 In Rev. Proc , the IRS adds that a failure to reach a resolution on the VCP submission means "the matter will be closed, the compliance fee will not be returned, and the case may be referred to Employees Plans Examination." In the event of an anonymous submission, the IRS will refund only 50% of the applicable VCP fee In order to correct "excess amounts" in a Section 403(b) arrangement under VCP, the employer or the funding agent must demonstrate that it is unable to make a corrective distribution. Under EPCRS, sponsors of Section 403(b) arrangements may correct "excess amounts" - that is, a contribution or allocation that is in excess of the limits under Section 415 (and for years prior to 2002, the Section 403(b)(2) exclusion allowance limit for the year 48 ) - by retaining such amounts in the arrangement. The excess amount is then used to reduce the affected participants' applicable Section 415 limit for future years. Previously, a VCT application and the payment of a compliance fee (the applicable fee, plus 10% of the excess amount) were required to correct this failure. 49 Under Rev. Proc , the VCT application is replaced by an application under VCP and, more important, there is a new requirement that either the employer or the funding agent demonstrate that it is "unable to make a correcting distribution." 50 CONCLUSION Although Rev. Proc does not make many of the substantive changes currently suggested by various professional retirement plan organizations, it does accomplish the following: 1. Simplify the procedures through consolidation of the IRS-supervised voluntary programs into VCP. 2. Substantially lower the filing fee for correcting defects other than operational failures. 3. Bring SIMPLE IRAs into the remedial programs. 4. Provide correction guidance for both SIMPLE IRAs and SEPs. 5. Encourage small businesses to fully participate in voluntary compliance. All of these are welcome changes and make the remedial programs generally more available to plan sponsors. While Audit CAP is essentially unchanged, both the elimination of the compliance fee factor in determining the sanction and the likelihood that EP audit activity will increase with the end of the GUST remedial amendment period place a high premium on the ability to (1) conduct effective self-audits, (2) implement appropriate selfcorrections, and (3), if a defect is discovered by the IRS on audit, negotiate an advantageous form of correction

12 and a reasonable sanction. Finally, Rev. Proc did not materially change SCP. Therefore, it is imperative that plan sponsors continue to take great care in self-correcting significant operational defects and in determining what is a significant vs. insignificant defect. ENDNOTES 1 A "qualified plan" is a plan that satisfies the requirements of Section 401 (a). Qualified plans include defined benefit plans, profit sharing plans, money purchase pension plans, Section 401 (k) plans, and stock bonus plans, including employee stock ownership plans. A Section 403(b) arrangement is a deterred compensation retirement vehicle sponsored by a tax-exempt organization that satisfies the requirements of Section 403(b). Because Section 403(b) arrangements were originally required to be invested in annuity contracts, they are often referred to as "tax-sheltered annuity plans." For purposes of simplicity and completeness, this article will refer to retirement vehicle satisfying Section 403(b) as "arrangements" although the authors recognize that many such arrangements amount to "plans" as defined in Title 1 of ERISA. 2 Plan disqualification results in the following: (1) the plan sponsor loses its deduction for contributions to the plan during the open tax years under the statute of limitations to the extent the contribution is not vested for the plan participants (see Section 404(e)(5)); (2) for a defined benefit plan, plan disqualification results in a total loss of the deduction (other than for a one-person plan) (see Reg (a)-12(b)); (3) for tax years still open under the statute of limitations, the employee recognizes as income the vested portion of his or her plan benefit (see Sections 402(b) and 6501); (4) for tax years still open under the applicable statute of limitations, the plan's related trust recognizes any earnings as income for income tax purposes see Section 501 (a)); and (5) distributions become ineligible for special tax treatment and cannot be rolled over on a tax-deferred basis (e.g., any amounts rolled over to an IRA or another qualified plan would not be excluded from income by reason of the rollover) (see Section 402(d)). 3 Under EPCRS, a defect in a qualified plan is referred to as a "qualification failure," which is any operational or form problem that adversely affects the qualification of a plan. See Rev. Proc , IRB 1051, section 5.01(2). A defect in a Section 4031bl arrangement is called a "403(b) failure," which, as a practical matter, has the same meaning as a qualification failure. Id., section 5.02(2). Qualification failures and 403(b) failures are referred to in this article as either "failures" or "defects." 4 For a complete discussion of Rev. Proc , CB 723, see Reish and Ashton, "IRS Consolidates Its Qualified Plan Correction Programs Into EPCRS," 88 JTAX 325 (June 1998). 5 The current definitions of "operational failure are in Rev. Proc , sections 5.01(2)(b) (for qualified plans) and 5.02(2)(a) (for Section 403(b) arrangements) 6 The current definition of "plan document failure "is in Rev. Proc , section 5.01 (2)(a). 7 The current definitions of "demographic failure are in Rev. Proc , sections 5.01(2)(c) (for qualified plans) and 5.02(2)(b) (for Section 403(b) arrangements). 8 Rev. Proc , section 5.08, contains the following examples of an gregious operational failure: "if an employer has consistently and improperly covered only highly compensated employees or if a contribution to a defined contribution plan for a highly compensated individual is several times greater than the dollar limit set forth in 415, the failure would be considered egregious." The same examples originally appeared in Rev. Proc. 9822, section The phrase "diversion of misuse of plan assets" is referred to in Rev. Proc , section 5.09, and proscribed by Section 401(a)(2).